LESSON 1: THE FINANCIAL MARKET ENVIRONMENT CAEC 07

SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

SHADOW BANKING SYSTEM

FINANCIAL INSTITUTIONS & MARKETS
The shadow banking system describes a group of
Firms that require funds from external sources can institutions that:
obtain them in three ways: ➔​ engage in lending activities, much like
1.​ through a financial institution traditional banks but do not accept deposits
2.​ through financial markets ➔​ are not subject to the same regulations as
3.​ through private placements traditional banks

FINANCIAL INSTITUTIONS GLASS-STEAGALL ACT

●​ Financial institutions are intermediaries that ➔​ The Glass-Steagall Act was an act of
channel the savings of individuals, Congress in 1933 that created the federal
businesses, and governments into loans or deposit insurance program and separated the
investments. activities of commercial and investment
●​ The key suppliers and demanders of funds banks. It was repealed in 1999 by Congress.
are individuals, businesses, and
governments. MATTER OF FACT:
●​ In general, individuals are net suppliers of Consolidation in the U.S. Banking Industry:
funds, while businesses and governments ●​ The U.S. banking industry has been going
are net demanders of funds. through a long period of consolidation.
●​ According to the FDIC, the number of
COMMERCIAL BANKS commercial banks in the United States
declined from 11,463 in 1992 to 6,048 in
Commercial banks are institutions that: 2013, a decline of 47%.
➔​ provide savers with a secure place to invest ●​ The decline is concentrated among small,
their funds community banks, which larger institutions
➔​ offer loans to individual and business have been acquiring at a rapid pace.
borrowers
FINANCIAL MARKETS
INVESTMENT BANKS
●​ Financial markets are forums in which
Investment banks are institutions that: suppliers of funds and demanders of funds
can transact business directly.
➔​ assist companies in raising capital
➔​ advise firms on major transactions such as ●​ Transactions in short term marketable
mergers or financial restructurings securities take place in the money market
while transactions in long-term securities
➔​ engage in trading and market making
activities take place in the capital market.

CAEC 07: FINANCIAL MARKETS LESSON #1 | ROSARIO, NHERIE KRIZIA F. | 22-BSA-03 | 24-2134-793
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SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

●​ A private placement involves the sale of a ●​ Most money market transactions are made in
new security directly to an investor or group marketable securities which are short-term
of investors. debt instruments, such as:
●​ Most firms, however, raise money through a ○​ U.S. Treasury bills issued by the
public offering of securities, which is the sale federal government
of either bonds or stocks to the general ○​ commercial paper issued by
public. businesses
●​ The primary market is the financial market in ○​ negotiable certificates of deposit
which securities are initially issued; the only issued by financial institutions
market in which the issuer is directly ●​ Investors generally consider marketable
involved in the transaction. securities to be among the least risky
●​ Secondary markets are financial markets in investments available.
which preowned securities (those that are ●​ The international equivalent of the domestic
not new issues) are traded. (U.S.) money market is the Eurocurrency
market.
TWO TYPES OF FINANCIAL MARKETS ●​ The Eurocurrency market is a market for
short-term bank deposits denominated in
U.S. dollars or other marketable currencies.
1.​ Primary Market
●​ The Eurocurrency market has grown rapidly
2.​ Secondary Market
mainly because it is unregulated and
because it meets the needs of international
FLOW OF FUNDS
borrowers and lenders.
●​ Nearly all Eurodollar deposits are time
deposits.

THE CAPITAL MARKET

●​ The capital market is a market that enables

suppliers and demanders of long-term funds
to make transactions.
●​ The key capital market securities are bonds
(long-term debt) and both common and
preferred stock (equity, or ownership).
○​ Bonds are long-term debt
THE MONEY MARKET
instruments used by businesses
and government to raise large sums
●​ The money market is created by a financial of money, generally from a diverse
relationship between suppliers and group of lenders.
demanders of short-term funds. ○​ Common stock are units of
ownership interest or equity in a
corporation.

CAEC 07: FINANCIAL MARKETS LESSON #1 | ROSARIO, NHERIE KRIZIA F. | 22-BSA-03 | 24-2134-793
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SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

○​ Preferred stock is a special form of DEALER MARKETS

ownership that has features of
both a bond and common stock.
●​ Dealer markets, such as Nasdaq, are markets
EXAMPLE: in which the buyer and seller are not brought
●​ Lakeview Industries, a major microprocessor together directly but instead have their
manufacturer, has issued a 9 percent coupon orders executed by securities dealers that
interest rate, 20-year bond with a $1,000 par “make markets” in the given security.
value that pays interest semiannually.
●​ The dealer market has no centralized trading
○​ Investors who buy this bond floors. Instead, it is made up of a large
receive the contractual right to $90 number of market makers who are linked
annual interest (9% coupon interest together via a mass-telecommunications
rate $1,000 par value) distributed network.
as $45 at the end of each 6 months
●​ As compensation for executing orders,
(1/2 $90) for 20 years. market makers make money on the spread
○​ Investors are also entitled to the (bid price – ask price).
$1,000 par value at the end of year
20. MATTER OF FACT:
According to the World Federation of Exchanges, in
FOCUS ON PRACTICE: 2012:
Berkshire Hathaway – Can Buffett Be Replaced?
1.​ NYSE Euronext is the largest stock market in
●​ Since the early 1980s, Berkshire Hathaway’s the world, as measured by the total market
Class A common stock price has climbed from value of securities listed on that market.
$285/share to $114,000/share. NYSE Euronext has listed securities worth
●​ The company is led by Chairman Warren more than $14.1 trillion in the U.S. and $2.1
Buffett (83) and Vice-Chairman Charlie trillion in Europe.
Munger (89).
2.​ The second largest exchange is Nasdaq, with
●​ The share price of BRKA has never been split. listed securities valued at $4.6 trillion.
Why might the company refuse to split its
3.​ The Tokyo Stock Exchange has securities
shares to make them more affordable to valued at $3.5 trillion.
average investors?
4.​ The fourth largest exchange, the London
Stock Exchange, has securities valued at $3.3
BROKER MARKETS trillion.

●​ Broker markets are securities exchanges on

which the two sides of a transaction, the INTERNATIONAL CAPITAL MARKETS
buyer and seller, are brought together to
trade securities.
1.​ Eurobond Market
●​ Trading takes place on centralized trading 2.​ Foreign bond market
floors of national exchanges, such as NYSE
3.​ International equity market
Euronext, as well as regional exchanges.

CAEC 07: FINANCIAL MARKETS LESSON #1 | ROSARIO, NHERIE KRIZIA F. | 22-BSA-03 | 24-2134-793
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SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

EUROBOND MARKET psychology, argue that stock prices and prices

of other securities can deviate from their
true values for extended periods.
➔​ In the Eurobond market corporations and
●​ Examples of the principle that stock prices
governments typically issue bonds
sometimes can be wildly inaccurate
denominated in dollars and sell them to
measures of value include:
investors located outside the United States.
○​ the huge run up and subsequent
collapse of the prices of Internet
FOREIGN BOND MARKET
stocks in the late 1990s
○​ the failure of markets to
➔​ The foreign bond market is a market for accurately assess the risk of
bonds issued by a foreign corporation or mortgage-backed securities in the
government that is denominated in the more recent financial crisis
investor’s home currency and sold in the
investor’s home market. FOCUS ON ETHICS:
●​ The Ethics of Insider Trading
INTERNATIONAL EQUITY MARKET ●​ Bryan Shaw received inside information on
Herbalife and Skechers from Scott London, a
➔​ The international equity market allows KPMG auditor. Using this information, Shaw
corporations to sell blocks of shares to made $1.3 million in trading profits. He
investors in a number of different countries pleaded guilty to insider trading charges in
simultaneously. 2013.
●​ Laws prohibiting insider trading were
established in the United States in the 1930s.
ROLES OF CAPITAL MARKETS
These laws are designed to ensure that all
investors have access to relevant information
●​ From a firm’s perspective, the role of capital
on the same terms.
markets is to be a liquid market where firms
●​ Some market participants believe that insider
can interact with investors in order to obtain
trading should be permitted, arguing that
valuable external financing resources.
information about the trades of insiders
●​ From investors’ perspectives, the role of
would be useful information to the market.
capital markets is to be an efficient market
QUESTIONS:
that allocates funds to their most productive
●​ If efficiency is the goal of financial markets, is
uses.
allowing or disallowing insider trading more
●​ An efficient market allocates funds to their
unethical?
most productive uses as a result of
●​ Does allowing insider trading create an
competition among wealth-maximizing
ethical dilemma for insiders?
investors and determines and publicizes
prices that are believed to be close to their
THE FINANCIAL CRISIS
true value.
●​ Advocates of behavioral finance, an emerging
field that blends ideas from finance and

CAEC 07: FINANCIAL MARKETS LESSON #1 | ROSARIO, NHERIE KRIZIA F. | 22-BSA-03 | 24-2134-793
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 LESSON 1: THE FINANCIAL MARKET ENVIRONMENT CAEC 07

SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

FINANCIAL INSTITUTIONS AND The price of bank stocks fell 81% between January
REAL ESTATE FINANCE 2008 and March 2009.

SECURITIZATION

➔​ Securitization is the process of pooling

mortgages or other types of loans and then
selling claims or securities against that pool
in a secondary market.

MORTAGE-BACKED SECURITIES

➔​ represent claims on the cash flows

generated by a pool of mortgages and can be
purchased by individual investors, pension
funds, mutual funds, or virtually any other
investor.
➔​ A primary risk associated with
mortgage-back securities is that
homeowners may not be able to, or may
choose not to, repay their loans.

FALLING HOME PRICES AND

DELINQUENT MORTGAGES

●​ Rising home prices between 1987 and 2006

kept mortgage default rate low.
●​ Lenders relaxed standards for borrowers and
created subprime mortgages.
●​ As housing prices fell from 2006 to 2009,
many borrowers had trouble making
payments, but were unable to refinance.
●​ As a result, there was a sharp increase in the
number of delinquencies and foreclosures.

CRISIS OF CONFIDENCE IN BANKS

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SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

and trading, thereby effectively separating

commercial banks from investment banks.

GRAMM-LEACH-BLILEY ACT (1999)

●​ The Gramm-Leach-Bliley Act (1999) allows

business combinations (e.g. mergers)
between commercial banks, investment
banks, and insurance companies, and thus
permits these institutions to compete in
markets that prior regulations prohibited
SPILLOVER EFFECT AND THE GREAT RECESSION them from entering.
●​ Congress passed the Dodd-Frank Wall Street
●​ As banks came under intense financial Reform and Consumer Protection Act in
pressure in 2008, they tightened their 2010, but it has not been fully implemented.
lending standards and dramatically reduced
the quantity of loans they made. REGULATIONS GOVERNING FINANCIAL MARKETS
●​ Corporations found that they could no longer
raise money in the money market, or could SECURITIES ACT OF 1933
only do so at extraordinarily high rates.
●​ As a consequence, businesses began to hoard
➔​ The Securities Act of 1933 regulates the sale
cash and cut back on expenditures, and
of securities to the public via the primary
economic activity contracted.
market.
➔​ Requires sellers of new securities to provide
REGULATION OF FINANCIAL INSTITUTIONS extensive disclosures to the potential buyers
AND MARKETS of those securities

REGULATIONS GOVERNING FINANCIAL SECURITIES EXCHANGE ACT OF 1934

INSTITUTIONS
➔​ The Securities Exchange Act of 1934
GLASS-STEAGALL ACT (1933) regulates the trading of securities such as
stocks and bonds in the secondary market.
●​ The Glass-Steagall Act (1933) established the ➔​ Created the Securities Exchange
Federal Deposit Insurance Corporation Commission, which is the primary
(FDIC) which provides insurance for deposits government agency responsible for
at banks and monitors banks to ensure their enforcing federal securities laws.
safety and soundness. ➔​ Requires ongoing disclosure by companies
●​ The Glass-Steagall Act also prohibited whose securities trade in secondary markets
institutions that took deposits from engaging (e.g., 10-Q, 10-K).
in activities such as securities underwriting

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SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

➔​ Imposes limits on the extent to which ●​ A firm’s marginal tax rate represents the rate
“insiders” can trade in their firm’s securities. at which additional income is taxed.
●​ The average tax rate is the firm’s taxes
BUSINESS TAXES divided by taxable income.

INTEREST AND DIVIDEND INCOME

●​ For corporations only, 70% of all dividend

●​ Both individuals and businesses must pay income received from an investment in the
taxes on income. stock of another corporation in which the
●​ The income of sole proprietorships and firm has less than 20% ownership is excluded
partnerships is taxed as the income of the from taxation.
individual owners, whereas corporate ●​ This exclusion moderates the effect of
income is subject to corporate taxes. double taxation, which occurs when after-tax
●​ Both individuals and businesses can earn two corporate earnings are distributed as cash
types of income—ordinary income and dividends to stockholders, who then must
capital gains income. pay personal taxes on the dividend amount.
●​ Under current law, tax treatment of ordinary ●​ Unlike dividend income, all interest income
income and capital gains income change received is fully taxed.
frequently due frequently changing tax laws.
TAX-DEDUCTIBLE EXPENSES
ORDINARY INCOME
●​ In calculating taxes, corporations may deduct
●​ Ordinary income is earned through the sale operating expenses and interest expense but
of a firm’s goods or services and is taxed at not dividends paid.
the rates depicted in Table 2.1 on the ●​ This creates a built-in tax advantage for using
previous slide. debt financing as the following example will
demonstrate.

BUSINESS TAXATION

MARGINAL VS. AVERAGE TAX RATES

CAEC 07: FINANCIAL MARKETS LESSON #1 | ROSARIO, NHERIE KRIZIA F. | 22-BSA-03 | 24-2134-793
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SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

LG2 Contrast the functions of financial institutions

and financial markets.
●​ Financial institutions collect the savings of
individuals and channel those funds to
borrowers such as businesses and
governments.
●​ As the example shows, the use of debt ●​ Financial markets provide a forum in which
financing can increase cash flow and EPS, and savers and borrowers can transact business
decrease taxes paid. directly.
●​ The tax deductibility of interest and other LG3 Describe the differences between the capital
certain expenses reduces their actual markets and the money markets.
(after-tax) cost to the profitable firm. ●​ In the money market, savers who want a
●​ It is the non-deductibility of dividends paid temporary place to deposit funds where they
that results in double taxation under the can earn interest interact with borrowers
corporate form of organization. who have a short-term need for funds.
●​ In contrast, the capital market is the forum in
CAPITAL GAINS which savers and borrowers interact on a
long-term basis.
●​ A capital gain is the amount by which the LG4 Explain the root causes and subsequent effects of
sale price of an asset exceeds the asset’s the 2008 financial crisis and recession.
purchase price. ●​ Financial institutions lowered their
●​ For corporations, capital gains are added to standards for lending to prospective
ordinary income and taxed like ordinary homeowners and invested heavily in
income at the firm’s marginal tax rate. mortgage-backed securities.
●​ When home prices fell and mortgage
delinquencies rose, the value of the
mortgage-backed securities held by banks
plummeted, causing some banks to fail and
many others to restrict the flow of credit to
business. That contributed to a severe
recession in the United States and abroad.
LG5 Understand the major regulations and regulatory
REVIEW OF LEARNING GOALS bodies that affect financial institutions and markets.
●​ The Glass-Steagall Act created the FDIC and
imposed a separation between commercial
LG1: Understand the role that financial institutions
and investment banks. The Act was designed
play in managerial finance.
to limit the risks that banks could take and to
●​ Financial institutions bring net suppliers of
protect depositors.
funds and net demanders together to help
●​ Recently, the Gramm-Leach-Bliley Act
translate the savings of individuals,
essentially repealed the elements of
businesses, and governments into loans and
Glass-Steagall pertaining to the separation of
other types of investments.

CAEC 07: FINANCIAL MARKETS LESSON #1 | ROSARIO, NHERIE KRIZIA F. | 22-BSA-03 | 24-2134-793
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SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

commercial and investment banks. After the

recent financial crisis, much debate has
occurred regarding the proper regulation of
large financial institutions.
●​ The Securities Act of 1933 focuses on
regulating the sale of securities in the
primary market,
●​ whereas the Securities Exchange Act of 1934
deals with regulations governing transactions
in the secondary market. The 1934 Act also
created the Securities and Exchange
Commission, the primary body responsible
for enforcing federal securities laws.
LG6 Discuss business taxes and their importance in
financial decisions.
●​ Corporate income is subject to corporate
taxes.
●​ Corporate tax rates apply to both ordinary
income (after deduction of allowable
expenses) and capital gains. The average tax
rate paid by a corporation ranges from 15 to
35 percent.
●​ Corporate taxpayers can reduce their taxes
through certain provisions in the tax code:
dividend income exclusions and
tax-deductible expenses.
●​ A capital gain occurs when an asset is sold
for more than its initial purchase price; they
are added to ordinary corporate income and
taxed at regular corporate tax rates.

CAEC 07: FINANCIAL MARKETS LESSON #1 | ROSARIO, NHERIE KRIZIA F. | 22-BSA-03 | 24-2134-793
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 LESSON 2: TIME VALUE OF MONEY CAEC 07

SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

ELECTRONIC SPREADSHEETS
FUTURE VALUE VS. PRESENT VALUE
●​ Like financial calculators, electronic
spreadsheets have built-in routines that
simplify time value calculations.
●​ In this text:
○​ The value for each variable is
entered in a cell in the
spreadsheet, and the calculation is
programmed using an equation
that links the individual cells.
○​ Changing any of the input
variables automatically changes
Figure 2.1 Compounding vs. discounting the solution as a result of the
equation linking the cells.
●​ To make the right investment decision,
managers need to compare the cash flows at CASH FLOW SIGNS
a single point in time.
●​ When making investment decisions, ●​ To provide a correct answer, financial
managers usually calculate present value. calculators and electronic spreadsheets
require that a calculation’s relevant cash
COMPUTATIONAL TOOLS flows be entered accurately as cash inflows
or cash outflows.
●​ Cash inflows are indicated by entering
positive values.
●​ Cash outflows are indicated by entering
negative values.

BASIC PATTERNS OF CASH FLOW

Figure 2.2 Calculator Keys

●​ A single amount: A lump sum amount either

●​ Financial calculators include preprogrammed
held currently or expected at some future
financial routines.
date.
●​ Computational tools:
●​ An annuity: A level periodic stream of cash
○​ Electronic Spreadsheets
flow.
○​ Cashflow signs
●​ A mixed stream: A stream of unequal
periodic cash flows.

CAEC 07: FINANCIAL MARKETS LESSON #1 | ROSARIO, NHERIE KRIZIA F. | 22-BSA-03 | 24-2134-793
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 LESSON 2: TIME VALUE OF MONEY CAEC 07

SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

FUTURE VALUE OF A SINGLE AMOUNT FVn = PV ´ (1 + r)n

Parts of Future Value: PRESENT VALUE OF A SINGLE AMOUNT

●​ Future Value
●​ Compound Interest Parts of Present Value:
●​ Principal ●​ Present Value
●​ Discounting cash flows
FUTURE VALUE ●​ Discount rate

➔​ Future Value is the value at a given future PRESENT VALUE

date of an amount placed on deposit today
and earning interest at a specified rate. ➔​ Present Value is the current dollar value of a
➔​ Found by applying compound interest over a future amount—the amount of money that
specified period of time. would have to be invested today at a given
interest rate over a specified period to equal
COMPOUND INTEREST the future amount.
➔​ It is based on the idea that a dollar today is
worth more than a dollar tomorrow.
➔​ Compound Interest is interest that is earned
on a given deposit and has become part of
the principal at the end of a specified DISCOUNTING CASH FLOWS
period.
➔​ Discounting Cash Flows is the process of
PRINCIPAL finding present values; the inverse of
compounding interest.
➔​ is the amount of money on which interest is
paid. DISCOUNT RATE

THE EQUATION FOR FUTURE VALUE ➔​ The discount rate is often also referred to as
the opportunity cost, the discount rate, the
We use the following notation for the various inputs: required return, or the cost of capital.
●​ FVn = future value at the end of period n
●​ PV = initial principal, or present value THE EQUATION FOR PRESENT VALUE
●​ r = annual rate of interest paid. (Note: On
financial calculators, I is typically used to The present value, PV, of some future amount, FVn, to
represent this rate.) be received n periods from now, assuming an interest
●​ n = number of periods (typically years) that rate (or opportunity cost) of r, is calculated as follows:
the money is left on deposit
The general equation for the future value at the end of
period n is

CAEC 07: FINANCIAL MARKETS LESSON #1 | ROSARIO, NHERIE KRIZIA F. | 22-BSA-03 | 24-2134-793
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 LESSON 2: TIME VALUE OF MONEY CAEC 07

SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

ORDINARY ANNUITY

ORDINARY ANNUITY OF FUTURE VALUE

●​ You can calculate the future value of an

ordinary annuity that pays an annual cash
flow equal to CF by using the following
equation:
ANNUITIES

An annuity is a stream of equal periodic cash flows,

over a specified time period. These cash flows can be
inflows of returns earned on investments or outflows
of funds invested to earn future returns. ●​ As before, in this equation r represents the
interest rate and n represents the number of
Types of Annuities: payments in the annuity (or equivalently, the
●​ Ordinary Annuity number of years over which the annuity is
●​ Annuity Due spread).

ORDINARY ANNUITY ORDINARY ANNUITY OF PRESENT VALUE

●​ You can calculate the present value of an

➔​ An ordinary (deferred) annuity is an annuity
ordinary annuity that pays an annual cash
for which the cash flow occurs at the end of
flow equal to CF by using the following
each period
equation:

ANNUITY DUE

➔​ An annuity due is an annuity for which the

cash flow occurs at the beginning of each
●​ As before, in this equation r represents the
period.
interest rate and n represents the number of
payments in the annuity (or equivalently, the
NOTE:
number of years over which the annuity is
➔​ An annuity due will always be greater than
spread).
an otherwise equivalent ordinary annuity
because interest will compound for an
additional period.

CAEC 07: FINANCIAL MARKETS LESSON #1 | ROSARIO, NHERIE KRIZIA F. | 22-BSA-03 | 24-2134-793
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SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

ANNUITY DUE

ANNUITY DUE OF FUTURE VALUE

COMPOUNDING INTEREST
●​ You can calculate the present value of an
annuity due that pays an annual cash flow
equal to CF by using the following equation: Compounding interest more frequently than annually:
●​ Compounding more frequently than once a
year results in a higher effective interest
rate because you are earning interest on
interest more frequently.
●​ As before, in this equation r represents the
●​ As a result, the effective interest rate is
interest rate and n represents the number of
greater than the nominal (annual) interest
payments in the annuity (or equivalently, the
rate.
number of years over which the annuity is
●​ Furthermore, the effective rate of interest
spread).
will increase the more frequently interest is
compounded.
ANNUITY DUE OF PRESENT VALUE

COMPOUNDING INTEREST OF FUTURE VALUE

●​ You can calculate the present value of an
ordinary annuity that pays an annual cash
A general equation for compounding more frequently
flow equal to CF by using the following
than annually
equation:

●​ As before, in this equation r represents the

interest rate and n represents the number of
payments in the annuity (or equivalently, the CONTINUOUS COMPOUNDING
number of years over which the annuity is
spread).
●​ Continuous compounding involves the
compounding of interest an infinite number
PERPETUITY of times per year at intervals of
microseconds.
●​ A perpetuity is an annuity with an infinite
life, providing continual annual cash flow.
●​ If a perpetuity pays an annual cash flow of CF,
starting one year from now, the present
●​ A general equation for continuous
value of the cash flow stream is
compounding where e is the exponential
function.

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SOPHOMORE CLASS | S.Y. 2024-2025 | 2ND SEMESTER | VISPERAS, KIM

interest rate equals the amount of initial

NOMINAL AND EFFECTIVE ANNUAL RATES principal borrowed.
●​ The following equation calculates the equal
periodic loan payments (CF) necessary to
●​ The nominal (stated) annual rate is the
contractual annual rate of interest charged provide a lender with a specified interest
by a lender or promised by a borrower. return and to repay the loan principal (PV)
over a specified period:
●​ The effective (true) annual rate (EAR) is the
annual rate of interest actually paid or
earned.
●​ In general, the effective rate > nominal rate
LOAN AMORTIZATION SCHEDULE
whenever compounding occurs more than
once per year
➔​ A loan amortization schedule is a schedule
of equal payments to repay a loan. It shows
the allocation of each loan payment to
interest and principal.

FINDING INTEREST OR GROWTH RATES

SPECIAL APPLICATIONS OF TIME VALUE
●​ It is often necessary to calculate the
compound annual interest or growth rate
DEPOSITS NEEDED TO ACCUMULATE A FUTURE SUM
(that is, the annual rate of change in values)
of a series of cash flows.
The following equation calculates the annual cash ●​ The following equation is used to find the
payment (CF) that we’d have to save to achieve a interest rate (or growth rate) representing
future value (FVn): the increase in value of some investment
between two time periods.

LOAN AMORTIZATION

●​ Loan Amortization is the determination of

the equal periodic loan payments necessary
to provide a lender with a specified interest
return and to repay the loan principal over a FINDING AN UNKNOWN NUMBER OF PERIODS
specified period.
●​ The loan amortization process involves ●​ Sometimes it is necessary to calculate the
finding the future payments, over the term of number of time periods needed to generate
the loan, whose present value at the loan

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a given amount of cash flow from an initial LG3 Find the future value and the present value of
amount. both an ordinary annuity and an annuity due, and
●​ This simplest case is when a person wishes find the present value of a perpetuity.
to determine the number of periods, n, it ●​ The future or present value of an ordinary
will take for an initial deposit, PV, to grow to annuity can be found by using algebraic
a specified future amount, FVn, given a equations, a financial calculator, or a
stated interest rate, r. spreadsheet program.
●​ The value of an annuity due is always r%
REVIEW OF LEARNING GOALS greater than the value of an identical annuity.
●​ The present value of a perpetuity—an
LG1 Discuss the role of time value in finance, the use infinite-lived annuity—is found using 1
of computational tools, and the basic patterns of cash divided by the discount rate to represent the
flow. present value interest factor.
LG4 Calculate both the future value and the present
●​ Financial managers and investors use
time-value-of-money techniques when value of a mixed stream of cash flows.
assessing the value of expected cash flow ●​ A mixed stream of cash flows is a stream of
streams. unequal periodic cash flows that reflect no
particular pattern.
●​ Alternatives can be assessed by either
compounding to find future value or ●​ The future value of a mixed stream of cash
discounting to find present value. flows is the sum of the future values of each
individual cash flow.
●​ Financial managers rely primarily on present
value techniques. ●​ Similarly, the present value of a mixed
stream of cash flows is the sum of the
●​ The cash flow of a firm can be described by
its pattern—single amount, annuity, or present values of the individual cash flows.
mixed stream. LG5 Understand the effect that compounding interest
LG2 Understand the concepts of future value and more frequently than annually has on future value
present value, their calculation for single amounts, and the effective annual rate of interest.
and the relationship between them. ●​ Interest can be compounded at intervals
ranging from annually to daily, and even
●​ Future value (FV) relies on compound
interest to measure future amounts: The continuously.
initial principal or deposit in one period, ●​ The more often interest is compounded, the
along with the interest earned on it, becomes larger the future amount that will be
the beginning principal of the following accumulated, and the higher the effective,
period. or true, annual rate (EAR).
LG6 Describe the procedures involved in (1)
●​ The present value (PV) of a future amount is
the amount of money today that is determining deposits needed to accumulate a future
equivalent to the given future amount, sum, (2) loan amortization, (3) finding interest or
considering the return that can be earned. growth rates, and (4) finding an unknown number of
Present value is the inverse of future value. periods.
●​ (1) The periodic deposit to accumulate a
given future sum can be found by solving the

CAEC 07: FINANCIAL MARKETS LESSON #1 | ROSARIO, NHERIE KRIZIA F. | 22-BSA-03 | 24-2134-793
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equation for the future value of an annuity

for the annual payment.
●​ (2) A loan can be amortized into equal
periodic payments by solving the equation
for the present value of an annuity for the
periodic payment.
●​ (3) Interest or growth rates can be estimated
by finding the unknown interest rate in the
equation for the present value of a single
amount or an annuity.
●​ (4) An unknown number of periods can be
estimated by finding the unknown number of
periods in the equation for the present value
of a single amount or an annuity.

CAEC 07: FINANCIAL MARKETS LESSON #1 | ROSARIO, NHERIE KRIZIA F. | 22-BSA-03 | 24-2134-793
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➔​ The real rate of interest changes with

INTEREST RATES & REQUIRED RETURNS changing economic conditions, tastes, and
preferences.

INTEREST RATE FUNDAMENTALS

INTEREST RATE

➔​ Interest rate is usually applied to debt

instruments such as bank loans or bonds; the
compensation paid by the borrower of funds
to the lender; from the borrower’s point of
view, the cost of borrowing funds.

REQUIRED RETURN

➔​ Required return is usually applied to equity

➔​ The supply-demand relationship that
instruments such as common stock; the cost
determines the real rate is shown in Figure
of funds obtained by selling an ownership
6.1 on the following slide.
interest.

NOMINAL OR ACTUAL RATE OF INTEREST (RETURN)

FACTORS INFLUENCING THE
EQUILIBRIUM INTEREST RATE
➔​ The nominal rate of interest is the actual rate
of interest charged by the supplier of funds
1.​ Inflation, which is a rising trend in the prices
and paid by the demander.
of most goods and services.
➔​ The nominal rate differs from the real rate of
2.​ Risk, which leads investors to expect a higher
interest, r* as a result of two factors:
return on their investment
◆​ Inflationary expectations reflected
3.​ Liquidity preference, which refers to the
in an inflation premium (IP), and
general tendency of investors to prefer
◆​ Issuer and issue characteristics
short-term securities
such as default risks and
contractual provisions as reflected
THE REAL RATE OF INTEREST in a risk premium (RP).

➔​ The real rate of interest is the rate that

creates equilibrium between the supply of
NOMINAL RATE OF INTEREST FORMULA
savings and the demand for investment funds
in a perfect world, without inflation, where The nominal rate of interest for security 1, r1, is given
suppliers and demanders of funds have no by the following equation:
liquidity preferences and there is no risk.

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security purchased on a given day and held

to maturity.

YIELD CURVES

The nominal rate can be viewed as having two basic

components: a risk-free rate of return, RF, and a risk
premium, RP1:

RISK FREE RATE RETURN FORMULA

●​ A normal yield curve is an upward-sloping
yield curve indicates that long-term interest
●​ For the moment, ignore the risk premium,
rates are generally higher than short-term
RP1, and focus exclusively on the risk-free
interest rates.
rate. The risk free rate can be represented as:
●​ An inverted yield curve is a
RF = r* + IP downward-sloping yield curve indicates that
●​ The risk-free rate (as shown in the preceding short-term interest rates are generally higher
equation) embodies the real rate of interest than long-term interest rates.
plus the expected inflation premium. ●​ A flat yield curve is a yield curve that
●​ The inflation premium is driven by investors’ indicates that interest rates do not vary much
expectations about inflation—the more at different maturities.
inflation they expect, the higher will be the
inflation premium and the higher will be the
THEORIES OF TERM STRUCTURE
nominal interest rate.

Three theories are frequently cited to explain the

TERM STRUCTURE OF INTEREST RATES
general shape of the yield curve:
●​ Expectations theory
●​ The term structure of interest rates is the ●​ Liquidity preference theory
relationship between the maturity and rate ●​ Market segmentation theory
of return for bonds with similar levels of risk.
●​ A graphic depiction of the term structure of
EXPECTATIONS THEORY
interest rates is called the yield curve.
●​ The yield to maturity is the compound
annual rate of return earned on a debt

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➔​ Expectations theory is the theory that the ●​ The risk premium varies with specific issuer
yield curve reflects investor expectations and issue characteristics.
about future interest rates; an expectation
of rising interest rates results in an DEBT-SPECIFIC RISK PREMIUM COMPONENTS
upward-sloping yield curve, and an
expectation of declining rates results in a
DEFAULT RISK
downward-sloping yield curve.

➔​ The possibility that the issuer of debt will not

LIQUIDITY PREFERENCE THEORY
pay the contractual interest or principal as
scheduled.
➔​ Liquidity preference theory suggests that
➔​ The greater the uncertainty as to the
long-term rates are generally higher than
borrower's ability to meet these payments,
short-term rates (hence, the yield curve is
the greater the risk premium. High bond
upward sloping) because investors perceive
ratings reflect low default risk, and low bond
short-term investments to be more liquid and
ratings reflect high default risk.
less risky than long-term investments.
➔​ Borrowers must offer higher rates on
MATURITY RISK
long-term bonds to entice investors away
from their preferred short-term securities.
➔​ That the longer the maturity, the more the
MARKET SEGMENTATION THEORY value of a security will change in response to
a given change in interest rates. If interest
rates on otherwise similar-risk securities
➔​ Market segmentation theory suggests that
suddenly rise, the prices of long-term bonds
the market for loans is segmented on the
will decline by more than the prices of
basis of maturity and that the supply of and
short-term bonds and vice versa."
demand for loans within each segment
determine its prevailing interest rate;
➔​ The slope of the yield curve is determined by CONTRACTUAL PROVISION RISK
the general relationship between the
prevailing rates in each market segment. ➔​ Conditions that are often included in a debt
agreement or a stock issue. Some of these
RISK PREMIUMS reduce risk, whereas others may increase
risk. For example, a provision allowing a
bond issuer to retire its bonds prior to their
ISSUE AND ISSUER CHARACTERISTICS maturity under favorable terms increases the
bond's risk.
●​ The nominal rate of interest for a security is
equal to the risk-free rate (consisting of the CORPORATE BONDS
real rate of interest plus the inflation
expectation premium) plus the risk premium.
CORPORATE BOND

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practices that the bond issuer must follow;

●​ A corporate bond is a long-term debt normally, they do not place a burden on a
instrument indicating that a corporation has financially sound business.
borrowed a certain amount of money and
promises to repay it in the future under RESTRICTIVE COVENANTS
clearly defined terms.
➔​ Restrictive covenants are provisions in a
COUPON INTEREST RATE bond indenture that place operating and
financial constraints on the borrower.
●​ The coupon interest rate is the percentage of
a bond’s par value that will be paid annually, The most common restrictive covenants do the
typically in two equal semiannual payments, following:
as interest. 1.​ Require a minimum level of liquidity, to
ensure against loan default.
BOND’S PAR VALUE, OR FACE VALUE 2.​ Prohibit the sale of accounts receivable to
generate cash. Selling receivables could
cause a long-run cash shortage if proceeds
●​ The bond’s par value, or face value, is the
were used to meet current obligations.
amount borrowed by the company and the
3.​ Impose fixed-asset restrictions. The
amount owed to the bond holder on the
borrower must maintain a specified level of
maturity date.
fixed assets to guarantee its ability to repay
BOND’S MATURITY DATE
the bonds.
4.​ Constrain subsequent borrowing. Additional
●​ The bond’s maturity date is the time at long-term debt may be prohibited, or
which a bond becomes due and the principal additional borrowing may be subordinated to
must be repaid. the original loan. Subordination means that
subsequent creditors agree to wait until all
LEGAL ASPECTS OF CORPORATE BONDS claims of the senior debt are satisfied.
5.​ Limit the firm’s annual cash dividend
payments to a specified percentage or
BOND INDENTURE
amount.

➔​ The bond indenture is a legal document that

SINKING FUND REQUIREMENTS
specifies both the rights of the bondholders
and the duties of the issuing corporation.
➔​ Sinking fund requirements are a restrictive
provision often included in a bond indenture,
STANDARD DEBT PROVISIONS
providing for the systematic retirement of
bonds prior to their maturity.
➔​ Standard debt provisions are provisions in a
bond indenture specifying certain
SECURITY INTEREST
record-keeping and general business

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➔​ A conversion feature for convertible bonds

➔​ A security interest is a provision in the bond allows bondholders to change each bond into
indenture that identifies any collateral a stated number of shares of common stock.
pledged against the bond and how it is to be ➔​ Bondholders will exercise this option only
maintained. The protection of bond collateral when the market price of the stock is greater
is crucial to guarantee the safety of a bond than the conversion price.
issue.
CALL FEATURE
TRUSTEE
➔​ A call feature, which is included in nearly all
➔​ A trustee is a paid individual, corporation, or corporate bond issues, gives the issuer the
commercial bank trust department that acts opportunity to repurchase bonds at a stated
as the third party to a bond indenture and call price prior to maturity.
can take specified actions on behalf of the ➔​ The call price is the stated price at which a
bondholders if the terms of the indenture are bond may be repurchased, by use of a call
violated. feature, prior to maturity.
COST OF BONDS TO THE ISSUER ➔​ The call premium is the amount by which a
bond’s call price exceeds its par value.
➔​ In general, the call premium is equal to one
●​ In general, the longer the bond’s maturity,
year of coupon interest and compensates the
the higher the interest rate (or cost) to the
holder for having it called prior to maturity.
firm.
➔​ Furthermore, issuers will exercise the call
●​ In addition, the larger the size of the offering,
feature when interest rates fall and the
the lower will be the cost (in % terms) of the
issuer can refund the issue at a lower cost.
bond.
➔​ Issuers typically must pay a higher rate to
●​ Also, the greater the default risk of the
investors for the call feature compared to
issuing firm, the higher the cost of the issue.
issues without the feature.
●​ Finally, the cost of money in the capital
market is the basis form determining a
bond’s coupon interest rate. STOCK PURCHASE WARRANTS

GENERAL FEATURES OF A BOND ISSUE ➔​ Bonds also are occasionally issued with stock
purchase warrants, which are instruments
that give their holders the right to purchase a
●​ Conversion feature
certain number of shares of the issuer’s
●​ Call feature
common stock at a specified price over a
●​ Stock purchase warrants
certain period of time. Occasionally attached
to bonds as “sweeteners.”
CONVERSION FEATURE
➔​ Including warrants typically allows the firm to
raise debt capital at a lower cost than would
be possible in their absence.

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BOND YIELDS contingent

only on
The three most widely cited yields are: earnings
●​ Current yield being
available.
●​ Yield to maturity (YTM)
●​ Yield to call (YTC)

SECURED BONDS
CHARACTERISTICS AND PRIORITY OF LENDER’S
CLAIM OF TRADITIONAL TYPES OF BONDS
BOND TYPE CHARACTERISTICS PRIORITY

UNSECURED BONDS MORTGAGE Secured by real Claim is on

BONDS estate or buildings. proceeds from
sale of
BOND TYPE CHARACTERISTICS PRIORITY mortgaged
assetsις if not
DEBENTURES Unsecured bonds Claims are fully satisfied,
that only the same as the lender
creditworthy firms those of any becomes a
can issue. general general creditor.
Convertible bonds creditor. May The
are normally have other first-mortgage
debentures. unsecured claim must be
bonds fully satisfied
subordinated before
to them. distribution of
proceeds to
SUBORDINATED Claims are not Claim is that second
DEBENTURES satisfied until of a general mortgage
those of the creditor but holders and so
creditors holding not as good on. A number of
certain (senior) as a senior mortgages can
debts have been debt claim. be issued against
fully satisfied. the same
collateral.
INCOME BONDS Payment of Claim is that
interest is required of a general COLLATERAL Secured by stock Claim is on
only when creditor. Are TRUST BONDS and (or) bonds proceeds from
earnings are not in default that are owned by stock and/or
available. when interest the issuer. bond collateral;
Commonly issued payments are Collateral value is if not fully
in reorganization missed generally 25% to satisfied, the
of a failing firm. because they 35% greater than lender becomes
are bond value. a gen-eral

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BOND TYPE CHARACTERISTICS PRIORITY

CHARACTERISTICS OF CONTEMPORARY
creditor. TYPES OF BONDS

EQUIPMENT Used to finance Claim is on

TRUST "rolling stock," proceeds from ZERO - (OR LOW-) COUPON BONDS
CERTIFICATES such as airplanes, the sale of the
trucks, boats, asset, if ➔​ Issued with no (zero) or a very low coupon
railroad cars. A proceeds do not (stated interest) rate and sold at a large
trustee buys the satisfy
discount from par. A significant portion (or
asset with funds outstanding
raised through the debt, trust all) of the investor's return comes from gain
sale of trust cer-tificate in value (that is, par value minus purchase
certifi-cates and lenders become price). Generally callable at par value.
then leases it to general creditors
the firm; af-ter
JUNK BONDS
making the final
scheduled lease
payment, the firm ➔​ Debt rated Ba or lower by Moody's or BB or
receives title to the lower by Standard & Poor's. Commonly used
asset. A type of by rapidly growing firms to obtain growth
leasing.
capital, most often as a way to finance
mergers and takeovers. High-risk bonds with
INTERNATIONAL BOND ISSUES high yields, often yielding 2% to 3% more
than the best-quality corporate debt.
●​ Companies and governments borrow
internationally by issuing bonds in two FLOATING-RATE BONDS
principal financial markets:
○​ A Eurobond is a bond issued by an ➔​ Stated interest rate is adjusted periodically
international borrower and sold to within stated limits in response to changes in
investors in countries with specified money market or capital market
currencies other than the currency rates. Popular when future inflation and
in which the bond is denominated. interest rates are uncertain. Tend to sell at
○​ In contrast, a foreign bond is a close to par because of the automatic
bond issued in a host country’s adjustment to changing market conditions.
financial market, in the host Some issues provide for annual redemption
country’s currency, by a foreign at par at the option of the bondholder.
borrower.
●​ Both markets give borrowers the opportunity EXTENDIBLE NOTES
to obtain large amounts of long-term debt
financing quickly, in the currency of their
➔​ Short maturities, typically 1 to 5 years, that
choice and with flexible repayment terms.
can be renewed for a similar period at the

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option of holders. Similar to a floating-rate 1.​ Cash flows (returns)

bond. An issue might be a series of 3-year 2.​ Timing
renewable notes over a period of 15 years; 3.​ A measure of risk, which
every 3 years, the notes could be extended determines the required return
for another 3 years, at a new rate
competitive with market interest rates at the BOND FUNDAMENTALS
time of renewal.
●​ As noted earlier, bonds are long-term debt
PUTABLE BONDS instruments used by businesses and
governments to raise large sums of money,
➔​ Bonds that can be redeemed at par (typically, typically from a diverse group of lenders.
$1,000) at the option of their holder either at ●​ Most bonds pay interest semiannually at a
specific dates after the date of issue and stated coupon interest rate, have an initial
every 1 to 5 years thereafter or when and if maturity of 10 to 30 years, and have a par
the firm takes specified actions, such as value of $1,000 that must be repaid at
being acquired, acquiring another company, maturity.
or issuing a large amount of additional debt.
In return for conferring the right to "put the BOND VALUE BEHAVIOR
bond" at specified times or when the firm
takes certain actions, the bond's yield is In practice, the value of a bond in the marketplace is
lower than that of a non-putable bond. rarely equal to its par value.

MOODY’S & STANDARD & POOR’S BOND RATINGS ●​ Whenever the required return on a bond
differs from the bond’s coupon interest rate,
the bond’s value will differ from its par value.
●​ The required return is likely to differ from the
coupon interest rate because either
○​ (1) economic conditions have
changed, causing a shift in the
basic cost of long-term funds, o
○​ (2) the firm’s risk has changed.
●​ Increases in the basic cost of long-term funds
or in risk will raise the required return;
decreases in the cost of funds or in risk will
lower the required return.
BONDS VALUATION

●​ Valuation is the process that links risk and

return to determine the worth of an asset.
●​ There are three key inputs to the valuation
process:

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INTEREST RATE RISK risk-free rate is the real rate of interest plus
an inflation premium.
●​ For any class of similar-risk securities, the
➔​ Interest rate risk is the chance that interest
term structure of interest rates reflects the
rates will change and thereby change the
relationship between the interest rate or rate
required return and bond value.
of return and the time to maturity. Yield
➔​ Rising rates, which result in decreasing bond
curves can be downward sloping (inverted),
values, are of greatest concern.
upward sloping (normal), or flat. The
➔​ The shorter the amount of time until a
expectations theory, liquidity preference
bond’s maturity, the less responsive is its
theory, and market segmentation theory are
market value to a given change in the
cited to explain the shape of the yield curve.
required return.
Risk premiums for non-Treasury debt issues
result from business risk, financial risk,
YIELD TO MATURITY (YTM)
interest rate risk, liquidity risk, tax risk,
default risk, maturity risk, and contractual
➔​ The yield to maturity (YTM) is the rate of provision risk.
return that investors earn if they buy a bond
at a specific price and hold it until maturity. LG2​ Review the legal aspects of bond financing
(Assumes that the issuer makes all scheduled and bond cost.
interest and principal payments as ●​ Corporate bonds are long-term debt
promised.) instruments indicating that a corporation has
➔​ The yield to maturity on a bond with a borrowed an amount that it promises to
current price equal to its par value will repay in the future under clearly defined
always equal the coupon interest rate. terms. The bond indenture, enforced by a
➔​ When the bond value differs from par, the trustee, states all conditions of the bond
yield to maturity will differ from the coupon issue. It contains both standard debt
interest rate. provisions and restrictive covenants, which
may include a sinking-fund requirement
REVIEW OF LEARNING GOALS and/or a security interest. The cost of a bond
to an issuer depends on its maturity, offering
LG1​ Describe interest rate fundamentals, the size, and issuer risk and on the basic cost of
term structure of interest rates, and risk premiums. money.
●​ The flow of funds between savers and LG3​ Discuss the general features, yields, prices,
borrowers is regulated by the interest rate or ratings, popular types, and international issues of
required return. In a perfect, inflation-free, corporate bonds.
certain world there would be one cost of ●​ A bond issue may include a conversion
money—the real rate of interest. The feature, a call feature, or stock purchase
nominal or actual interest rate is the sum of warrants. The yield, or rate of return, on a
the risk-free rate and a risk premium bond can be measured by its current yield,
reflecting issuer and issue characteristics. The yield to maturity (YTM), or yield to call (YTC).
Bond prices are typically reported along with

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their coupon, maturity date, and yield to LG6​ Explain yield to maturity (YTM), its
maturity (YTM). Bond ratings by independent calculation, and the procedure used to value bonds
agencies indicate the risk of a bond issue. that pay interest semiannually.
●​ Various types of traditional and
contemporary bonds are available. ●​ Yield to maturity is the rate of return
Eurobonds and foreign bonds enable investors earn if they buy a bond at a specific
established creditworthy companies and price and hold it until maturity.
governments to borrow large amounts ●​ YTM can be calculated by using a financial
internationally. calculator or by using an Excel spreadsheet.
●​ Bonds that pay interest semiannually are
LG4​ Understand the key inputs and basic model valued by using the same procedure used to
used in the valuation process. value bonds paying annual interest, except
●​ Key inputs to the valuation process include that the interest payments are one-half of
cash flows (returns), timing, and risk and the the annual interest payments, the number of
required return. The value of any asset is periods is twice the number of years to
equal to the present value of all future cash maturity, and the required return is one-half
flows it is expected to provide over the of the stated annual required return on
relevant time period. similar-risk bonds.

LG5​ Apply the basic valuation model to bonds

and describe the impact of required return and time
to maturity on bond values.

●​ The value of a bond is the present value of its

interest payments plus the present value of
its par value.
●​ The discount rate used to determine bond
value is the required return, which may differ
from the bond’s coupon interest rate. The
amount of time to maturity affects bond
values.
●​ The value of a bond will approach its par
value as the bond moves closer to maturity.
●​ The chance that interest rates will change
and thereby change the required return and
bond value is called interest rate risk.
●​ The shorter the amount of time until a
bond’s maturity, the less responsive is its
market value to a given change in the
required return.

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○​ Their claims on income cannot be

STOCK VALUATIONS paid until the claims of all creditors,
including both interest and
scheduled principal payments, have
DIFFERENCE BETWEEN DEBT & EQUITY
been satisfied.
●​ Because equity holders are the last to receive
distributions, they expect greater returns to
compensate them for the additional risk they
bear.

MATURITY
DEBT
●​ Unlike debt, equity capital is a permanent
form of financing.
➔​ includes all borrowing incurred by a firm,
●​ Equity has no maturity date and never has to
including bonds, and is repaid according to a
be repaid by the firm.
fixed schedule of payments.

TAX TREATMENT
EQUITY

●​ Interest payments to debtholders are

➔​ consists of funds provided by the firm’s
treated as tax-deductible expenses by the
owners (investors or stockholders) that are
issuing firm.
repaid subject to the firm’s performance.
●​ Dividend payments to a firm’s stockholders
are not tax-deductible.
VOICE IN MANAGEMENT ●​ The tax deductibility of interest lowers the
corporation’s cost of debt financing, further
●​ Unlike creditors, holders of equity causing it to be lower than the cost of equity
(stockholders) are owners of the firm. financing.
●​ Stockholders generally have voting rights
that permit them to select the firm’s COMMON VS. PREFERRED STOCK
directors and vote on special issues.
●​ In contrast, debtholders do not receive
voting privileges but instead rely on the COMMON STOCK
firm’s contractual obligations to them to be
their voice. ●​ Common stockholders, who are sometimes
referred to as residual owners or residual
CLAIMS ON INCOME AND ASSETS claimants, are the true owners of the firm.
●​ As residual owners, common stockholders
receive what is left—the residual—after all
●​ Equity Holders' claims on income and assets
other claims on the firms income and assets
are secondary to the claims of creditors.
have been satisfied.

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●​ They are assured of only one thing: that they PREEMPTIVE RIGHTS
cannot lose any more than they have
invested in the firm.
➔​ A preemptive right allows common
●​ Because of this uncertain position, common stockholders to maintain their proportionate
stockholders expect to be compensated with ownership in the corporation when new
adequate dividends and ultimately, capital shares are issued, thus protecting them from
gains. dilution of their ownership.

CLAIMS DILUTION OF OWNERSHIP

●​ The common stock of a firm can be privately

➔​ is a reduction in each previous shareholder’s
owned by an private investors, closely
fractional ownership resulting from the
owned by an individual investor or a small
issuance of additional shares of common
group of investors, or publicly owned by a
stock.
broad group of investors.
●​ The shares of privately owned firms, which
DILUTION OF EARNINGS
are typically small corporations, are generally
not traded; if the shares are traded, the
transactions are among private investors and ➔​ is a reduction in each previous shareholder’s
often require the firm’s consent. fractional claim on the firm’s earnings
●​ Large corporations are publicly owned, and resulting from the issuance of additional
their shares are generally actively traded in shares of common stock.
the broker or dealer markets.
RIGHTS
PAR VALUE
➔​ Rights are financial instruments that allow
●​ The par value of common stock is an stockholders to purchase additional shares at
arbitrary value established for legal a price below the market price, in direct
purposes in the firm’s corporate charter, and proportion to their number of owned shares.
can be used to find the total number of ➔​ Rights are an important financing tool
shares outstanding by dividing it into the without which shareholders would run the
book value of common stock. risk of losing their proportionate control of
●​ When a firm sells news shares of common the corporation.
stock, the par value of the shares sold is ➔​ From the firm’s viewpoint, the use of rights
recorded in the capital section of the balance offerings to raise new equity capital may be
sheet as part of common stock. less costly than a public offering of stock.
●​ At any time the total number of shares of
common stock outstanding can be found by
dividing the book value of common stock by
the par value.

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AUTHORIZED, OUTSTANDING, & ISSUED SHARES ➔​ Because most small stockholders do not
attend the annual meeting to vote, they may
sign a proxy statement transferring their
AUTHORIZED SHARES
votes to another party.
➔​ Existing management generally receives the
➔​ are the shares of common stock that a firm’s stockholders’ proxies, because it is able to
corporate charter allows it to issue. solicit them at company expense.

OUTSTANDING SHARES PROXY BATTLE

➔​ are issued shares of common stock held by ➔​ A proxy battle is an attempt by a

investors, this includes private and public nonmanagement group to gain control of the
investors. management of a firm by soliciting a
sufficient number of proxy votes.
TREASURY SHARES
SUPERVOTING SHARES
➔​ are issued shares of common stock held by
the firm; often these shares have been ➔​ Supervoting shares is stock that carries with
repurchased by the firm. it multiple votes per share rather than the
single vote per share typically given on
ISSUED SHARES regular shares of common stock.

➔​ are shares of common stock that have been NONVOTING COMMON STOCK
put into circulation.
➔​ Nonvoting common stock is common stock
Issued shares = outstanding shares + treasury stock that carries no voting rights; issued when the
firm wishes to raise capital through the sale
VOTING RIGHTS of common stock but does not want to give
up its voting control.
●​ Generally, each share of common stock
entitles its holder to one vote in the election DIVIDENDS
of directors and on special issues.
●​ Votes are generally assignable and may be ●​ The payment of dividends to the firm’s
cast at the annual stockholders’ meeting. shareholders is at the discretion of the
company’s board of directors.
PROXY STATEMENT ●​ Dividends may be paid in cash, stock, or
merchandise.
➔​ Proxy Statement is a statement transferring ●​ Common stockholders are not promised a
the votes of a stockholder to another party. dividend, but they come to expect certain

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payments on the basis of the historical ➔​ ADSs are issued in dollars to U.S. investors
dividend pattern of the firm. and are subject to U.S. securities laws.
●​ Before dividends are paid to common ➔​ ADSs give investors the opportunity to
stockholders any past due dividends owed to diversify their portfolios internationally.
preferred stockholders must be paid.
PREFERRED STOCK
INTERNATIONAL STOCK ISSUES
●​ Preferred stock gives its holders certain
●​ The international market for common stock is privileges that make them senior to common
not as large as that for international debt. stockholders.
●​ However, cross-border issuance and trading ●​ Preferred stockholders are promised a fixed
of common stock have increased dramatically periodic dividend, which is stated either as a
during the past 30 years. percentage or as a dollar amount.
●​ Stock Issued in Foreign Markets
○​ A growing number of firms are PAR-VALUE PREFERRED STOCK
beginning to list their stocks on
foreign markets.
➔​ Par-value preferred stock is preferred stock
○​ Issuing stock internationally both
with a stated face value that is used with the
broadens the company’s ownership
specified dividend percentage to determine
base and helps it to integrate itself
the annual dollar dividend.
in the local business environment.
○​ Locally traded stock can facilitate
NO-PAR PREFERRED STOCK
corporate acquisitions, because
shares can be used as an
acceptable method of payment. ➔​ No-par preferred stock is preferred stock
with no stated face value but with a stated
FOREIGN STOCKS IN U.S. MARKETS: annual dollar dividend.
AMERICAN DEPOSITARY RECEIPTS (ADRs)
BASIC RIGHTS OF PREFERRED STOCKHOLDERS
➔​ are dollar-denominated receipts for the
stocks of foreign companies that are held by ●​ Preferred stock is often considered
a U.S. financial institution overseas. quasi-debt because, much like interest on
debt, it specifies a fixed periodic payment
(dividend).
AMERICAN DEPOSITARY SHARES (ADSs)
●​ Preferred stock is unlike debt in that it has no
maturity date.
➔​ are securities, backed by American ●​ Because they have a fixed claim on the firm’s
depositary receipts (ADRs), that permit U.S. income that takes precedence over the claim
investors to hold shares of non-U.S. of common stockholders, preferred
companies and trade them in U.S. markets. stockholders are exposed to less risk.

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●​ Preferred stockholders are not normally retire the shares within a certain period time
given a voting right, although preferred and at a specified price.
stockholders are sometimes allowed to elect
one member of the board of directors. CONVERSION FEATURE

FEATURES OF PREFERRED STOCK ➔​ A conversion feature is a feature of

convertible preferred stock that allows
●​ Restrictive covenants holders to change each share into a stated
●​ Cumulative preferred stock number of shares of common stock.
●​ Noncumulative preferred stock
●​ Callable Feature ISSUING COMMON STOCK
●​ Conversion feature
●​ Initial financing for most firms typically
RESTRICTIVE COVENANTS comes from a firm’s original founders in the
form of a common stock investment.
➔​ Restrictive covenants including provisions ●​ Early stage debt or equity investors are
about passing dividends, the sale of senior unlikely to make an investment in a firm
securities, mergers, sales of assets, minimum unless the founders also have a personal
liquidity requirements, and repurchases of stake in the business.
common stock. ●​ Initial non-founder financing usually comes
first from private equity investors.
CUMULATIVE PREFERRED STOCK ●​ After establishing itself, a firm will often “go
public” by issuing shares of stock to a much
broader group.
➔​ Cumulative preferred stock is preferred stock
for which all passed (unpaid) dividends in
arrears, along with the current dividend, VENTURE CAPITAL
must be paid before dividends can be paid
to common stockholders. VENTURE CAPITAL

NONCUMULATIVE PREFERRED STOCK ➔​ Venture capital is privately raised external

equity capital used to fund early-stage firms
➔​ Noncumulative preferred stock is preferred with attractive growth prospects.
stock for which passed (unpaid) dividends do
not accumulate. VENTURE CAPITALISTS (VCs)

CALLABLE FEATURE ➔​ Venture capitalists (VCs) are providers of

venture capital; typically, formal businesses
➔​ A callable feature is a feature of callable that maintain strong oversight over the firms
preferred stock that allows the issuer to

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they invest in and that have clearly defined

professional VC firms,
exit strategies. which serve as the
general partner and
ANGEL CAPITALISTS (ANGELS) organize, invest, and
manage the partnership
using the limited
➔​ Angel capitalists (angels) are wealthy partners' funds; the
individual investors who do not operate as a professional VCs
business but invest in promising early-stage ultimately liquidate the
companies in exchange for a portion of the partnership and
firm’s equity. distribute the proceeds
to all partners.

ORGANIZATION OF VENTURE CAPITAL INVESTORS

DEAL STRUCTURE AND PRICING
ORGANIZATION DESCRIPTION
●​ Venture capital investments are made under
SMALL BUSINESS Corporations chartered legal contracts that clearly allocate
INVESTMENT by the federal
responsibilities and ownership interests
COMPANIES (SBICs) government that can
borrow at attractive between existing owners (founders) and the
rates from the U.S. VC fund or limited partnership
Treasury and use the ●​ Terms depend on factors related to the
funds to make venture original founders, business structure, stage
capital investments in of development, outlook, and other market
private companies.
and timing issues.
●​ Specific financial terms depend upon the
FINANCIAL VC FUNDS Subsidiaries of financial
institutions, particularly value of the enterprise, the amount of
banks, set up to help funding required, and the perceived risk of
young firms grow and, it the investment.
is hoped, become major ●​ To control the VC’s risk, various covenants
customers of the are included in agreements and the actual
institution.
funding provided may be staggered based on
the achievement of measurable milestones.
CORPORATE VC FUNDS Firms, sometimes
subsidiaries, established ●​ The contract will also have a defined exit
by nonfinancial firms, strategy.
typically to gain access ●​ The amount of equity to which the VC is
to new tech-nologies entitled depends on the value of the firm,
that the corporation can the terms of the contract, the exit terms, and
access to further its own
minimum compound annual rate of return
growth.
required by the VC on its investment.
VC LIMITED Limited partnerships
PARTNERSHIPS organized by

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GOING PUBLIC ➔​ The investment banker is responsible for

promoting the stock and facilitating the sale
When a firm wishes to sell its stock in the primary of the company’s IPO shares.
market, it has three alternatives.
1.​ A public offering, in which it offers its shares PROSPECTUS
for sale to the general public.
2.​ A rights offering, in which new shares are ➔​ The prospectus is a portion of a security
sold to existing shareholders. registration statement that describes the key
3.​ A private placement, in which the firm sells aspects of the issue, the issuer, and its
new securities directly to an investor or a management and financial position.
group of investors.
●​ Here we focus on the initial public offering RED HERRING
(IPO), which is the first public sale of a firm’s
stock.
➔​ A red herring is a preliminary prospectus
●​ The company must file a registration
made available to prospective investors
statement with the SEC.
during the waiting period between the
●​ Investment bankers and company officials
registration statement’s filing with the SEC
promote the company through a road show,
and its approval.
a series of presentations to potential
investors around the country and sometimes
overseas. THE INVESTMENT BANKER’S ROLE
●​ This helps investment bankers gauge the
demand for the offering which helps them to INVESTMENT BANKER
set the initial offer price.
●​ After the underwriter sets the terms, the SEC ➔​ An investment banker is a financial
must approve the offering. intermediary that specializes in selling new
security issues and advising firms with regard
INITIAL PUBLIC OFFERING (IPO) to major financial transactions.

➔​ IPOs are typically made by small, UNDERWRITING

fast-growing companies that either:
◆​ require additional capital to ➔​ Underwriting is the role of the investment
continue expanding, or banker in bearing the risk of reselling, at a
◆​ have met a milestone for going profit, the securities purchased from an
public that was established in a issuing corporation at an agreed-on price.
contract to obtain VC funding. ➔​ This process involves purchasing the security
➔​ The firm must obtain approval of current issue from the issuing corporation at an
shareholders, and hire an investment bank to agreed-on price and bearing the risk of
underwrite the offering. reselling it to the public at a profit.

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➔​ The investment banker also provides the ($25.25 sale price – $24 purchase
issuer with advice about pricing and other price).
important aspects of the issue. ○​ The members of the selling group
earn 75 cents for each share they
UNDERWRITING SYNDICATE sell ($26 sale price – $25.25
purchase price).
➔​ An underwriting syndicate is a group of
other bankers formed by an investment
banker to share the financial risk associated
with underwriting new securities.

SYNDICATE SHARES

➔​ The syndicate shares the financial risk

associated with buying the entire issue from
the issuer and reselling the new securities to
the public.
THE SELLING PROCESS FOR LARGE SECURITY ISSUE
SELLING GROUP
COMMON STOCK VALUATION
➔​ The selling group is a large number of
brokerage firms that join the originating ●​ Common stockholders expect to be rewarded
investment banker(s); each accepts through periodic cash dividends and an
responsibility for selling a certain portion of a increasing share value.
new security issue on a commission basis. ●​ Some of these investors decide which stocks
to buy and sell based on a plan to maintain a
COMPENSATION FOR UNDERWRITING broadly diversified portfolio.
●​ Other investors have a more speculative
motive for trading.
●​ Compensation for underwriting and selling
○​ They try to spot companies whose
services typically comes in the form of a
shares are undervalued—meaning
discount on the sale price of the securities.
that the true value of the shares is
○​ For example, an investment banker
greater than the current market
may pay the issuing firm $24 per
price.
share for stock that will be sold for
○​ These investors buy shares that
$26 per share.
they believe to be undervalued and
○​ The investment banker may then
sell shares that they think are
sell the shares to members of the
overvalued (i.e., the market price is
selling group for $25.25 per share.
greater than the true value).
In this case, the original investment
banker earns $1.25 per share

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MARKET EFFICIENCY stock prices. Advocates are commonly

referred to as “behaviorists.”
●​ Economically rational buyers and sellers use
their assessment of an asset’s risk and return FOCUS ON PRACTICE
to determine its value.
●​ In competitive markets with many active Understanding Human Behavior Helps Us Understand
participants, the interactions of many buyers Investor Behavior
and sellers result in an equilibrium price—the ●​ Regret theory deals with the emotional
market value—for each security. reaction people experience after realizing
●​ Because the flow of new information is they have made an error in judgment.
almost constant, stock prices fluctuate, ●​ Some investors rationalize their decision to
continuously moving toward a new buy certain stocks with “everyone else is
equilibrium that reflects the most recent doing it.” (Herding)
information available. This general concept is ●​ People have a tendency to place particular
known as market efficiency. events into mental compartments, and the
●​ Although considerable evidence supports the difference between these compartments
concept of market efficiency, a growing body sometimes impacts behavior more than the
of academic evidence has begun to cast events themselves.
doubt on the validity of this notion ●​ Prospect theory suggests that people express
a different degree of emotion toward gains
EFFICIENT-MARKET HYPOTHESIS (EMH) than losses.
Anchoring is the tendency of investors to place more
value on recent information.
➔​ The efficient-market hypothesis (EMH) is a
theory describing the behavior of an
assumed “perfect” market in which: BASIC COMMON STOCK VALUATION EQUATION
◆​ securities are in equilibrium,
◆​ security prices fully reflect all
available information and react
swiftly to new information, and ➔​ The value of a share of common stock is
◆​ because stocks are fully and fairly equal to the present value of all future cash
priced, investors need not waste flows (dividends) that it is expected to
time looking for mispriced provide.
securities. ➔​ Basically adds all future cash flows

BEHAVIORAL FINANCE THE ZERO GROWTH MODEL

➔​ Behavioral finance is a growing body of ➔​ The zero dividend growth model assumes
research that focuses on investor behavior that the stock will pay the same dividend
and its impact on investment decisions and each year, year after year.

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STEPS:
●​ Step 1. Find the value of the cash dividends
at the end of each year, Dt, during the initial
growth period, years 1 though N.
➔​ The equation shows that with zero growth, ●​ Step 2. Find the present value of the
the value of a share of stock would equal the dividends expected during the initial growth
present value of a perpetuity of D1 dollars period.
discounted at a rate rs. ●​ Step 3. Find the value of the stock at the end
of the initial growth period, PN = (DN+1)/(rs –
EXAMPLE: g2), which is the present value of all
●​ Chuck Swimmer estimates that the dividend dividends expected from year N + 1 to
of Denham Company, an established textile infinity, assuming a constant dividend growth
producer, is expected to remain constant at rate, g2.
$3 per share indefinitely. ●​ Step 4. Add the present value components
●​ If his required return on its stock is 15%, the found in Steps 2 and 3 to find the value of
stock’s value is: the stock, P0.
○​ $20 ($3 ÷ 0.15) per share
FREE CASH FLOW VALUATION MODEL
CONSTANT-GROWTH MODEL

➔​ The constant-growth model is a widely cited

dividend valuation approach that assumes
➔​ A free cash flow valuation model determines
that dividends will grow at a constant rate,
the value of an entire company as the
but a rate that is less than the required
present value of its expected free cash flows
return.
discounted at the firm’s weighted average
➔​ The Gordon model is a common name for
cost of capital, which is its expected average
the constant-growth model that is widely
future cost of funds over the long run.
cited in dividend valuation.

OTHER APPROACHES TO STOCK VALUATION

THE VARIABLE GROWTH MODEL

●​ Book value per share

●​ The zero- and constant-growth common
●​ Liquidation value per share
stock models do not allow for any shift in
●​ Price/earnings multiple approach
expected growth rates.
●​ The variable-growth model is a dividend
valuation approach that allows for a change BOOK VALUE PER SHARE
in the dividend growth rate.
●​ To determine the value of a share of stock in ●​ Book value per share is the amount per share
the case of variable growth, we use a of common stock that would be received if all
four-step procedure. of the firm’s assets were sold for their exact
book (accounting) value and the proceeds

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remaining after paying all liabilities (including Lamar Company found upon investigation that it could
preferred stock) were divided among the obtain only $5.25 million if it sold its assets today. The
common stockholders. firm’s liquidation value per share therefore would be
●​ This method lacks sophistication and can be
criticized on the basis of its reliance on
historical balance sheet data.
●​ It ignores the firm’s expected earnings
potential and generally lacks any true
relationship to the firm’s value in the PRICE/EARNINGS MULTIPLE APPROACH
marketplace.
●​ The price/earnings (P/E) ratio reflects the
EXAMPLE: amount investors are willing to pay for each
At year-end 2015, Lamar Company’s balance sheet dollar of earnings.
shows total assets of $6 million, total liabilities ●​ The price/earnings multiple approach is a
(including preferred stock) of $4.5 million, and 100,000 popular technique used to estimate the
shares of common stock outstanding. Its book value firm’s share value; calculated by multiplying
per share therefore would be the firm’s expected earnings per share (EPS)
by the average price/earnings (P/E) ratio for
the industry.

EXAMPLE:
Lamar Company is expected to earn $2.60 per share
LIQUIDATION VALUE PER SHARE next year (2016). Assuming a industry average P/E ratio
of 7, the firms per share value would be
●​ Liquidation value per share is the actual
amount per share of common stock that $2.60 7 = $18.20 per share
would be received if all of the firm’s assets
were sold for their market value, liabilities CHANGES IN EXPECTED DIVIDENDS
(including preferred stock) were paid, and
any remaining money were divided among
●​ Assuming that economic conditions remain
the common stockholders.
stable, any management action that would
●​ This measure is more realistic than book
cause current and prospective stockholders
value because it is based on current market
to raise their dividend expectations should
values of the firm’s assets.
increase the firm’s value.
●​ However, it still fails to consider the earning
●​ Therefore, any action of the financial
power of those assets.
manager that will increase the level of
expected dividends without changing risk
EXAMPLE:
(the required return) should be undertaken,
because it will positively affect owners’
wealth.

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EXAMPLE: Assume that Lamar Company manager makes a

decision that, without changing expected dividends,
Assume that Lamar Company announced a major causes the firm’s risk premium to increase to 7%.
technological breakthrough that would revolutionize its Assuming that the risk-free rate remains at 9%, the
industry. Current and prospective stockholders expect new required return on Lamar stock will be 16% (9% +
that although the dividend next year, D1, will remain at 7%).
$1.50, the expected rate of growth thereafter will
increase from ​
7% to 9%.

CHANGES IN RISK

●​ Any measure of required return consists of

two components: a risk-free rate and a risk
premium. We expressed this relationship as
in the previous chapter, which we repeat
here in terms of rs:

●​ Any action taken by the financial manager

that

increases the risk shareholders must bear will

also increase the risk premium required by
shareholders, and hence the required return.
●​ Additionally, the required return can be
affected by changes in the risk free
rate—even if the risk premium remains
constant.

EXAMPLE:

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